When a Chinese company goes public in the U.S., it typically does so through a U.S. corporation. Under the resulting ownership structure, the Chinese company is owned by the U.S. corporation, often indirectly through an intermediary corporation domiciled in a jurisdiction other than the United States or China (i.e., a foreign intermediary corporation). Because of this ownership structure, under prior law, any dividends paid by the Chinese company generally were subject to U.S. tax regardless of whether the dividends were paid to the U.S. corporation. After the enactment on May 17, 2006 of an expansion of the so-called "CFC look-through rule," dividends paid by a Chinese corporation to a foreign intermediary corporation under this structure generally are no longer subject to immediate U.S. tax, but remain free of U.S. tax unless and until distributed to the U.S. corporation.
Recent trends show that Chinese companies are going public and trading on the U.S. markets in large volume. Most Chinese companies undergo a restructuring before they go public in the United States. The restructuring involves a share exchange between the stockholders of the Chinese company and a newly formed offshore corporation typically domiciled in a tax haven such as the British Virgin Islands, the Cayman Islands, or Mauritius. The result of this type of transaction is that the Chinese company becomes a wholly-owned subsidiary of the foreign corporation and the former stockholders of the Chinese company become the owners of all of the equity of the foreign corporation. Because the Chinese company is wholly owned by the foreign corporation, it typically qualifies as a wholly foreign-owned enterprise ("WFOE") under Chinese law. To go public in the United States, the foreign corporation often effects a share exchange or a reverse merger with a U.S. public shell corporation. The result is that the foreign intermediary corporation becomes the wholly-owned subsidiary of the U.S. corporation and the stockholders of the foreign intermediary corporation become the controlling stockholders of the U.S. corporation.
Under the controlled foreign corporation ("CFC") rules (i.e., Subpart F) of the U.S. Internal Revenue Code (the "Code"), non-operating (or passive) income (i.e., Subpart F income) received by a CFC is generally subject to immediate taxation in the United States at a 35 percent tax rate, regardless of whether it is distributed to a U.S. shareholder. Under Subpart F, the WFOE and the foreign intermediary corporation are both CFCs of the U.S. corporation. Because the WFOE is typically engaged in active business activities, it typically has minimal (if any) Subpart F income and thus is not subject to significant U.S. tax under Subpart F. Before the enactment of the expanded CFC look-through rule, however, any dividends paid by the WFOE to the foreign intermediary corporation were considered Subpart F income of the foreign intermediary corporation and thus subject to immediate U.S. tax.
The New Law
On May 17, President Bush signed the Tax Increase Prevention and Reconciliation Act of 2005 ("TIPRA") into law. Section 103(b) of TIPRA added a temporary exception from Subpart F income for dividend, interest, rent, and royalty payments received by one CFC from a related CFC to the extent that the payment is attributable to non-Subpart F income of the payor (i.e., the expanded CFC look-through rule). This expanded CFC look-through rule is effective for tax years beginning after December 31, 2005 and before January 1, 2009.
Because of the enactment of the expanded CFC look-through rule, it is now possible for a WFOE owned by a U.S. corporation to pay dividends to a foreign intermediary corporation without incurring immediate U.S. tax. Consequently, investors in a WFOE owned through a U.S. corporation can now extract the earnings of the WFOE from China and redeploy those earnings outside of China without incurring any significant U.S. tax liability. The earnings will not be subject to U.S. tax unless and until they are distributed to the U.S. corporation.
The U.S. tax relief afforded by the CFC look-through rule is particularly significant to investors in a WFOE or any other Chinese foreign investment enterprises, because dividends paid by such entities to foreign shareholders generally are exempt from Chinese withholding tax. Because such dividends generally are not subject to tax in the tax haven jurisdiction of the foreign intermediary corporation either, the earnings can be extracted from China and redeployed elsewhere without incurring any worldwide tax liability. In effect, The expanded CFC look-through rule provides investors in Chinese WFOEs owned through U.S. corporations with tax-free access to U.S. public equity.
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